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June 21, 2013

The Rising Risks of Local Government Finances in Africa

Posted by Camille Karamaga

Recent studies by IMF staff indicate that sub-national governments are a significant source of fiscal risk in European countries, especially since the global financial crisis. One reason is that local governments are responsible for many similar functions and financial transactions as central governments. Depending on the depth of devolution, local governments may borrow, manage off-budget enterprises and engage in opaque transactions with the central government and other sectors. In many cases, unfortunately, their accounting and reporting systems are weaker than those of central government, as are the arrangements for external oversight.

In sub-Saharan Africa (SSA), as decentralization gains momentum, similar issues are arising. Although the overall size of the local government sector is still relatively small—on average around 5-10 percent of the national budget—in some countries the figures are much higher, and are growing from year to year. In Kenya, for example, the new Constitution provides for a minimum allocation of 15 percent of the most recently audited domestic revenues to county governments, and the allocation for the current financial year is around 26 percent. In Tanzania budgetary allocations to local government authorities in FY 2010/11 and FY 2011/12 were 21.2 percent and 25.3 percent of the national budget, respectively. Across the region, the trend in local government spending is on the rise as more governments decide, for largely political reasons, that decentralization promotes both better service delivery and enhanced local accountability.

The fiscal risks associated with this trend are evident. Political pressure to decentralize functions and service delivery may lead to a surge in expenditure responsibilities that is not matched by available resources. In the early years of decentralization, the process may be characterized by lack of coordination between ministries responsible for local government, and little attention to financial aspects of decentralization. Consequently, local governments are given expanded financial mandates but lack the required skills and capacity to support these new responsibilities. Moreover, shortcomings in the design of legal and institutional arrangements for fiscal decentralization, combined with a capacity deficit in the national finance ministry, create risks that may go undetected in the absence of adequate reporting and audit mechanisms.

As budgetary allocations to local governments continue to rise, so should capacity for good practices in fiscal reporting and financial management to promote transparency and accountability. Although many countries are reforming their PFM systems with a view to improving their reporting arrangements, in-year and end-year financial reporting practices still fall short of good practice. In many instances, coverage of fiscal reports remains limited to central government, and does not consolidate systematically information from local governments and other parts of general government. Fiscal risk analysis and fiscal transparency are still much in their infancy with limited internal demand for fiscal reports both within central government and external oversight bodies such as the parliament and the private sector.

Cognizant of the emergence of these fiscal risks, some countries are already taking steps to mitigate them. Governments in Sierra Leone, Uganda and Rwanda have established a variety of policies, systems and processes to strengthen fiscal oversight of local government finances. Such measures include strengthening the legal framework for local government finance; establishing local government finance commissions responsible for the design of fiscal transfers; implementing a transparent formula-based grants system; setting up units in the finance ministry responsible for managing intergovernmental finance issues; harmonizing the budget preparation cycle for central and local governments; and developing local government financial and accounting manuals to support improved financial reporting.

Policy-makers need to give due consideration to a number of factors in addressing the key areas of risk during the formulation of fiscal decentralization strategies. These factors include:

  • Designing an overarching policy on fiscal decentralization with clarity in the assignment of expenditure and revenue responsibilities;
  • Formulating an integrated PFM legal and regulatory framework for central government and local governments;
  • Assigning clear responsibilities within central government for policy issues related to devolution, thus ensuring that the ministry of finance’s mandate includes all policy issues relating to intergovernmental finance;
  • Establishing clear rules, procedures and guidelines for the devolution of functions, resources (financial and human) from line ministries to local governments;
  • Establishing clear rules regarding the authority for local governments to borrow and limit their accumulation of public debt in line with the country’s overall fiscal policy;
  • Defining clearly oversight and reporting responsibilities for local governments; and
  • To the extent possible, harmonizing the accounting and financial management policies across PFM areas in order to avoid proliferation of financial management manuals that may erode standards established at the national level.

In conclusion, the potential fiscal risks arising from devolution of public administration in the SSA region are substantial. While this trend cannot be reversed, its fiscal impact can be mitigated and controlled. The capacity of finance ministries to analyze local government finance issues, and take the lead in developing an appropriate policy framework, is at present, however, well below the level required, and in some SSA countries virtually non-existent.

Finance ministries should be involved from the outset in the formulation of fiscal decentralization policies and the accompanying legal and regulatory frameworks, while taking the lead on all fiscal aspects of intergovernmental relations, including strengthening of the required PFM capacities at local government level. Financial management practices and reforms at local government level should be embedded in the national PFM reform strategies and action plans. Most importantly, PFM laws and guidelines should be put in places that specify local government borrowing and fiscal reporting arrangements using a unified budget and accounting framework. Ministries of finance should have adequate fiscal oversight to ensure that spending by local governments is in line with the approved budget, and that reporting is carried out  in conformity with central government requirements. 

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy. 

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